How drugs turned toxic at Sigma

When
Elmo de Alwis
joined
Sigma Pharmaceuticals
as a cost accountant in 1977, he never expected that more than three decades later he would oversee a corporate disaster for a board that includes two of the nation’s most respected company directors.

Over almost nine years as chief executive, Mr de Alwis has run a drug manufacturer and pharmacy wholesale business that should have benefited from a stable industry structure, strong demographic positives, and federal government subsidies.

But the company was in disarray after it postponed the announcement of its full-year results last week.

It also faces a threat of shareholder class action over its alleged failure to disclose its financial woes when it raised $297 million through Deutsche Bank last September.

In the middle of it all is chairman
John Stocker
, a director of Telstra, Nufarm and the CSIRO, and risk management and audit committee chairman
Linda Nicholls
, chairman of Healthscope and a former chairman of Australia Post.

Sigma’s auditors, PricewaterhouseCoopers, are believed to be under pressure to retrospectively examine the asset-carrying values on the company’s balance sheet in the wake of the September capital raising to reduce debt.

Questions have arisen as to whether Sigma knew about the deterioration in the value of its intangible assets at the time of the raising.

“The market is telling you the book value is worthless," said one major investor. “The market is saying there’s a problem with the asset values on the balance sheet."

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Litigation funders said they had been contacted by brokers about potential class actions, but were waiting until Sigma released its results before deciding whether to commence legal action.

Sigma was struggling to meet interest payments on its debt and was trying to renegotiate coverage covenants with its banks (Australia and New Zealand Banking Group, Commonwealth Bank of Australia, National Australia Bank and Westpac Banking Corporation).

Analysts predicted the company could be forced to raise a further $150 million through a heavily dilutive capital raising in order to avoid a breach of its debt covenants, which could put Mr de Alwis in an untenable position after allegedly failing to disclose Sigma’s financial troubles during presentations late last year.

Sigma suspended trading in its shares four weeks ago, initially via a trading halt and then a full suspension, pending an announcement “in relation to revised earnings guidance arising from year-end adjustments".

Like the rest of the board, Mr de Alwis had remained tight-lipped about the company’s position throughout the suspension, but could face the wrath of investors when he delivers Sigma’s full-year results this week.

Sigma’s banks forced the company to reduce its gearing to 28.8 per cent at the time of its capital raising.

One theory is that the banks may want to push the company further this time and force it to reduce gearing to 25 per cent, which could require Sigma to raise up to $150 million.

While Sigma had not ruled out another capital raising to reduce debt, investors said it was more likely the group would sell assets to reduce debt as it renegotiated its loan terms with the big four banks.

Another theory was that Sigma would announce an overhaul of its strategy amid increasing pressure on its generics business.

Sigma is engaged in the manufacture, marketing and wholesale distribution of pharmaceutical products through pharmacy and grocery channels, and the provision of services to retail pharmacists.

But the company’s business model has come under pressure in recent years as the federal government’s pharmaceutical benefits scheme reforms forced pharmacists to seek cheaper prices and more generous trading terms from distributors.

The government is expected to reduce the subsidies paid to generic drug manufacturers, including Sigma and Australian Pharmaceutical Industries, by as much as 15 per cent in the federal budget. A five-year agreement between the powerful Pharmacy Guild of Australia and the government expires in July.

Every year the federal government pays more than $2 billion to pharmacists to dispense and supply medicine.

It is those payments, and subsidies to drug wholesalers such as Sigma and API that guarantee delivery to chemists, which are up for negotiation.

As drug distributors, Sigma and API are paid 9.5 per cent of the government’s subsidy for delivery of PBS-listed drugs and any cuts to generic subsidies will hit their revenue.

Sigma also has a long-standing practice of discounting and extending credit arrangements to customers such as Chemist Warehouse to help them expand. But the preferential treatment may have upset customers who do not have the same benefits – many smaller players have switched to Sigma’s competitors, API and Symbion Pharmacy Services.

“In the desire to build sales, they have given extended credit," said one industry insider. “The industry’s tough, we all know that. But if you keep extending cash cycles longer than what is normal and reasonable then eventually something’s got to give."

Market watchers expect Sigma could post a $150 million full-year net loss after goodwill impairment charges, below the $92 million profit predicted by analysts before the downgrade was flagged.

The downgrade came amid speculation that Sigma had continued enticing key pharmacist clients to bring forward sales orders in a bid to meet its end-of-year budget targets.

Industry insiders said the company continued offering to forward-charge the bulk of its February orders in January in order to meet its sales target for the year, given its January 31 year-end accounting date. But Sigma has followed this strategy for years, raising questions about why the company’s problems weren’t noticed earlier.

Investors are also concerned about its “Sigma Rewards" program, an off-balance securitisation debt deal with ANZ, Westpac and Allco Finance. Sigma disclosed that the rewards facility stood at $518.2 million in September, and market watchers expect this could now exceed $600 million.

Sigma’s net debt position was $89.6 million in September, but if auditors require the company to transfer the reward system debt onto the balance sheet, net debt could balloon to more than $700 million.

Sigma shares, which have not traded since February 24, last closed at 90¢, giving the company a market value of $1.06 billion.

The company’s financial distress has also intensified scrutiny of the takeover prices it paid for Arrow Pharmaceuticals and for parts of Bristol-Myers Squibb in Australia.

Increased competition in the generic drug market from overseas has driven down profit margins, reducing the value of the two businesses.

Sigma paid $700 million in cash to buy Arrow Pharmaceuticals in 2005 and $60 million to Bristol-Myers Squibb in September.

Sigma hoped the Arrow acquisition would be a springboard into the fast-growing generics market, then estimated to be worth about $700 million.

But analysts said revenue generated by Arrow following the merger had fallen short of projected earnings.

Sigma’s business strategy came under fire from industry experts who said the company’s attempts to grow multiple business units had hindered overall growth. “They really need to clarify what their business actually is," said one executive in the generic drugs manufacturing business.

“There are very few companies that can deliver growth with such a large number of different business units. You have different pockets of business, none of which can be leveraged to their optimum.

“The chances of another capital raising being effective would be very low. It’s more likely that either they have to recover in the long term by selling off part of the business or someone acquires them and breaks up the business."